The Economist - Japanese lessons

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Japanese lessons After five years of crisis, the euro area risks Japanese-style economic stagnation

FIVE years ago, things looked rosy. In the first week of August 2007 forecasts by investors and major central banks predicted growth rates of 2-3% in America and Europe. But on August 9th 2007 everything changed. A French bank, BNP Paribas, announced big losses on subprime-mortgage investments. The same day, the European Central Bank (ECB) was forced to inject €95 billion ($130 billion at the time) of emergency liquidity. The crisis had begun.

During the first year, policymakers looked to Japan as a guide, or rather a warning. Japan’s debt bubble had caused a “lost decade”, from 1991 to 2001. Analysts commonly drew three lessons. To avoid Japanese-style stagnation it was vital, first, to act fast; second, to clean up battered balance-sheets; and, third, to provide a bold economic stimulus. If Japan is taken as the yardstick, America and Britain have a mixed record. The euro area looks as if it might be turning Japanese.

Debts took years to build up. Take the American consumer. Debt was around 70% of GDP in 2000, and grew at around 4 percentage points a year to reach close to 100% of GDP by 2007. The same was true of European banks and governments: debts rose hugely but steadily. It was not hard to spot debt mountains forming.

The crisis erupted with the realisation that subprime exposures were widespread. Many assets were worth less in the market than they had been bought for. Debts started to look unsustainable and interest rates jumped. This meant governments, consumers and banks, after building up debt slowly, suddenly faced much higher costs, as debts matured and they were forced to refinance at higher rates.

The reaction was quick. By the end of 2008 the Federal Reserve, the ECB and the Bank of England had slashed official interest rates. Their aim was to offset the spike in debt costs that companies and consumers were facing. The cuts were fast by Japanese standards (see top right-hand chart). It seemed the first lesson had been learnt.

Falling asset prices meant that many banks and firms had debts that outweighed their assets. The Japanese experience showed that the next job was to deal with these broken balance-sheets. There are three main options: renegotiate debt, raise equity or go bankrupt.

In the efforts to reinvigorate balance-sheets, debt investors have reigned supreme. Debts have been honoured. Indeed, a recent report from Deutsche Bank shows that even investors in risky high-yield debt have had five great years. Bank bonds in America have returned 31%; in Europe, 25%.

As asset values fell, debt maintained its fixed value. This meant that equity, the balance-sheet shock-absorber, had to fall in value. So although debt caused the problem, equity took the pain. A Dow Jones index of bank equity is down by more than 60% since 2007, according to Deutsche Bank. Some banks’ share prices are down by more than 95%.

In many cases, the equity buffers were too small, so governments stepped in, taking equity stakes in banks. In both America and Europe governments stood behind their financial sectors. Balance-sheets were repaired. It seemed the second lesson from Japan had been learnt too.

But the clean-up just moved the problem on. Governments borrowed to fund the bail-outs. So banks’ balance-sheets were strengthened at the expense of public ones. America’s support for the banks cost 5% of GDP;